Bargain Buyer Beware

The soft market offers good deals, but watch out for prickly service and poor claims response.John P. Mello Jr., CFO MagazineSeptember 1, 1998

What started as just another dip in the insurance industry's boom-and-bust cycle has developed into a slide so prolonged that nothing appears capable of ending it. And with the hallmark low rates that the soft market brings to line after line of coverage, it seems a boon for everyone--except, of course, the insurance companies.

For insurers, the best that can be said is that their insurance products haven't quite become commodity items, despite the pressure of eroding revenues. Indeed, businesses appear prepared to help prevent that commodity scenario. Instead of gambling on further premium declines in the future, customers are still looking for multiyear policies that lock rates into the future. And rather than shop for the best price on individual coverages, they're seeking integrated or one-size-fits- all policies.

But even in such a soft market, some corporate customers see worrisome trends that are likely to increase even if insurers remain flexible on premiums.

Most concerns are over poorer treatment of claims as insurance moves toward commodity status, and insurers find themselves forced to price products below their costs. That could lead insurance companies to become decidedly tougher in the rulings governing payouts, as they work instead to help balance their revenue declines. Michael Kaminski, risk manager at Milwaukee-based Wisconsin Energy Corp., is one who sees this prospect. "The underwriting has gotten soft enough now that you could have some problems getting satisfactory claims recoveries down the road, especially if you're shopping based on price alone," he says.

Other options open to the stressed insurance companies include cutting services and limiting existing coverages, or excluding new areas. One obvious example in the last two categories is the difficulty of getting Year 2000 (Y2K) problems covered under policies purchased without that specific issue being included.

The servicing of insurance customers in this soft market is also an increasing problem for companies that rely on brokers, say some industry experts. Under pressure themselves to get better deals for clients, many brokers spend less time providing post-purchase client services that were once a large part of their job, says Rick Betterley, president of Betterley Risk Consultants, in Sterling, Massachusetts. "Insureds will get less face-to- face, hands-on service," he says, "because brokers have to spend more time just hanging on to accounts."

A longer-term concern for the customers now enjoying lower premiums will certainly be the industry consolidation that the soft market is helping to create. Recent mergers involved the acquisition of Industrial Indemnity by Fremont General, USF&G by St. Paul, Commercial Union by General Accident, and American States by Safeco--and more are likely on the horizon. "It's shaking out...that's quite clear," says Dan Heldman, Liberty Mutual Group's senior vice president for the mid- Atlantic division. Insurance companies are eager to increase company volume in what is essentially a finite-premium universe. And down the road, of course, mergers will dampen competition for a company in the market for a policy, and create a framework in which premium wars will be far less likely.

Reforms That WorkedHeldman and others think that today's soft market is a very different animal from markets of the past. Indeed, today's market may signal a fundamental change in the industry paradigm.

For one thing, claims are sharply lower, thanks to workers' compensation reform, the rise of managed health care, and the insurance industry's success in the courtroom. "Managed health care gets all the publicity in the group area," Heldman observes, "but in the property/ casualty area, managed care has really done a lot to mitigate medical costs for workers' compensation."

The industry's record has been remarkable "in winning cases and in holding down jury awards on appeal--despite the occasional headlines to the contrary," says Betterley. "The claims cost for insurance companies has been substantially lower than it was 10 years ago. That's making it easier to be competitive." The favorable loss record of recent years, particularly, feeds the soft market in another way. Since insurance companies charge premiums based on future losses, an unexpected dearth of losses creates a surplus of cash--cash that can be used to make balance sheets look rosy, even as premiums sink. "That can't go on permanently," notes James Blinn, an Ernst & Young LLP partner who oversees the firm's risk management consulting business.

Heldman estimates that from 10 percent to 30 percent of an insurer's premium goes to risk management costs, with the rest paying for losses. So if losses retreat, premiums will follow.

Softening things even more, Heldman adds, has been Wall Street's raging bull market, which until recently led to "an awful lot of capital chasing a finite amount of risk" and pressured insurance rates further downward.

Desperation or InnovationWhat is a shrinking premium pie for insurers, in most cases, looks like a luscious piece of cake for insurance-hungry companies. Last year, for example, the customer base in the mid-Atlantic region of Liberty Mutual grew 6 percent while revenues sank 10 percent. "That's pretty much what's going on throughout the industry," Heldman contends.

"What goes on here is really driven by the buyer," says Roland Bonitati, senior vice president of marketing at Johnston, Rhode Island­based Allendale Insurance, part of the Factory Mutual family of companies. "They have a really powerful influence on terms and conditions."

Although some observers contend that increased competition tagged to the soft market has stimulated innovation by insurers, Bonitati isn't one of them. Newer products, such as integrated coverages and multiyear offerings, are driven not by insurance companies, but by customers capitalizing on the industry's weakness, Bonitati explains. "There's no evidence that anyone [among the insurers] has changed their margins through innovation," he says, although "they may have gotten some market share."

Indeed, Ernst & Young's Blinn says with a laugh, "Sometimes there's a thin line between innovation and desperation."

A number of organizations have been lured from self-insurance to a premium-cutting carrier to assume company risks. That in itself can create a few risks--at least in efficiency, claims Blinn, who is also a director of the Self-Insurance Institute of America, a trade organization in Santa Ana, California. "When you give someone a guaranteed-cost program, there's a lot less incentive to be involved in controlling their losses," he says. "Companies act like they're outsourcing their responsibility for their losses."

"Once the market becomes financially driven, people make a leap of faith and jump over the fact that their underlying risks haven't changed," Bonitati adds. "They think about who's going to pay for a loss, not how to prevent a loss that could threaten their existence."

A Loss of ControlBut in general, the exodus from self-insurance is much smaller than many expected. Companies "can't escape their own losses," Liberty Mutual's Heldman says by way of explanation. "One way or another--either their experience rating or a history of their losses- -losses stay with them and affect their costs down the road. The property/casualty buyer wants a competitive price, but he also looks at who's going to do the job of preventing and managing loss. A company can save $30,000 on price, but if that carrier blows a workers' comp case, it may cost the company $200,000. Where's the savings there?"

And while companies may sometimes decrease the amount of risk they assume by lowering their policies' deductibles and retentions, "it isn't a major trend," Bonitati says, noting that, by and large, "Fortune 500 companies are still looking to their own balance sheets to cover risk."

"Buying insurance at the lower levels of risk, even at a great price, is still not a bargain if you don't really need the coverage," Dennis Kane, president of Special Risk Facilities, a business unit of Cigna Property & Casualty, in Philadelphia, told a group of insurance executives at an April meeting in San Diego sponsored by the Risk & Insurance Management Society. He contends that most companies would be better off making sure they have coverage for catastrophic losses that could affect the balance sheet or earnings per share, and retaining the lower layers of risk that are predictable and manageable.

Because of lower loss ratios, companies that lowered their retention rates in recent years actually did the insurance companies a favor. "Those companies that moved to a lower retention and a so-called discounted guaranteed cost program a couple of years ago will be happy to know that the insurance companies have taken the lion's share of the improvement in loss experience," he notes. "Meanwhile, the companies that retained higher limits shared in the rewards of lower loss costs within their retentions, as well as lower premiums for the excess-layer premiums."

"When we look at buying insurance here at Microsoft, we look at the pricing efficiency of the insurance products," says Scott Lange, director of risk management at the giant Redmond, Washington, software concern. "If it's reasonable to access external capital to respond to losses, we'll do that--even though we have lots of money as a corporation."

In selecting an insurer to replace your self- insurance, he says, "you have to look at the control issues you will face. Insurers may want to deal with a claim differently from the way you would. You give up [that decision- making power] when you buy insurance, and it's not always clear that that's a worthwhile trade."

The slimming of corporate staffs is another ingredient. "Today, many risk-management departments have been downsized, and this can be a fairly significant commitment," Bonitati notes. "They're going to have to weigh the ultimate benefits of a tremendous restructuring against the time they need to put into it."

Risk Managers, Not GamblersAlthough risk managers have "risk" in their title, most eschew taking chances when buying property/casualty insurance. Rather than pick a short-term policy and gamble on further rate decreases in the future, many still prefer locking in current low rates for several years. "Most risk managers can remember 1985, when rates started to go up," recalls Louis Drapeau, risk manager for The Budd Co., a Troy, Michigan, supplier to the automobile industry. "Those of us who had multiyear policies in place wound up being heroes because we anticipated the bottom of the market. You never know how low is too low, so you lock in a deal now, and hope to renegotiate the deal if the market gets softer."

Liberty Mutual's Heldman is seeing an increase in demand for multiyear policies. While price remains a consideration, companies like the level of risk-management performance they can get from an insurance company over the life of a multiyear policy, he contends. "They're asking us to do a lot more benchmarking of loss," he says. "They want to see how they compare to everyone in their SIC code, or how many losses go to litigation versus how many don't, or how soon losses are reported--a whole laundry list of things."

And for companies that can get their Y2K issues covered, says John Baily, a partner with Pricewaterhouse-Coopers LLP in Chicago, "there seems to be renewed interest in the multiyear policy right now. Companies want to make sure they have capacity in place as it relates to that problem."

Companies--especially large ones--are trying to use their soft-market leverage to win multiline policies as well. Such insurance is popular because it removes the administrative nightmare of negotiating a policy for each of a multitude of risks. At Budd, "we've used the market to get broader coverages," Drapeau says. And so has Wisconsin Energy. "Rather than just shopping for price, we've been more creative in broadening some coverages and combining coverages at our high-end layers," notes risk manager Kaminski.

"The bigger corporations are going for these integrated policies," says Microsoft Corp.'s Lange. "They're saying they want aggregate, blanket limits of protection covering all kinds of risk in one policy. We're certainly looking at that."

Insurers don't believe property/casualty is ever likely to reach commodity status, at least for midsized and large companies. "You can put a homeowners' policy on a spreadsheet, compare one price to another, and the basic policy probably isn't too different," Heldman explains. "But once you get into workers' compensation, fleet policies, product liability, and your property insurance, then it's got be serviced, or it will get away from you."

The Bottom of the WellA question both insurers and insureds are asking is how long the soft market can last. Among the potential spoilers, of course, would be if the recent stock-market correction led to a drying up of capital. There could be a series of real-life catastrophes.

Insurers may have been slow to adopt new technologies, experts say, but they have been adopting them nonetheless. That, together with the industry consolidations, has the companies reducing expenses in a way that will allow them to keep prices down for a while.

But the crystal ball is foggy past that. "At some point, the price is too low," says Betterley, and "the premium cost is less than providing the product. At that point, you harm the financial solvency of the insurance industry." But experts note that the insurance companies' claims performance is much better than it used to be, and that there are, as Betterley puts it, "higher reserves than necessary for the book of claims that any individual insurance company may have."

"This market won't end until the well runs dry," Blinn declares, "and we can't see the bottom of the well yet." That may be some time away. "The equity market has been so phenomenal that the companies just keep getting more and more money they have to burn up," he says. Adds Heldman, "Everyone asks, when will this cycle end? I don't know. It's like asking when there will be a correction to the stock market. But if something like that took place, it would change this marketplace."

Nevertheless, some see signs that the market is changing. The California Workman's Compensation market, once a price-cutting leader, "is turning around," Blinn says. "It's not as aggressive as it was in the past."

Even if the market firms up, though, it could be only temporary. "There are a lot of capital solutions to reinsurance out there, and they're waiting in the wings to do business that they haven't been able to do because of the soft market," observes Baily of PricewaterhouseCoopers. "That amounts to a whole second wave of capacity."

One alternative that could get more use is the catastrophe bond, called the Cat, or related vehicles underwritten for the reinsurance market by insurers like USAA, AIG, and Swiss Re. Rather than using reinsurance--which pools the resources of several insurance companies to take on the big hit of a catastrophic loss-- some insurers have chosen to sell the risk to investors, who receive one return if there's a catastrophe, and another, better return if there isn't. "Right now, the rates are so low in the direct insurance market, the buyer won't go to the capital market because it's a more complex product," Baily says. But if the rates tighten, he thinks it's possible that "the capital-market products will step in and hold the rates down."

This securitization of risk may not have to wait for a firming market to gain popularity, though. "When Cat bonds were introduced, they were overpriced by design," Bonitati says. "Since then, every one that's been done has been more competitive, until today we are in an environment in which these prices look similar to what it would cost for open-market catastrophe reinsurance."

As for the risk manager basking in the prospects of going to his board and boasting about yet another year of premium declines, Betterley has some advice. "Make sure that when you tell your boss you've gotten another 20 percent reduction, you credit the soft market for it," he suggests, "because when the market goes back up, you don't want to take the blame for it."